Editor's note

by Michael Avery

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Over the past forty years or so, the corporate world has been thriving on debt as government policymakers, particularly in the US and Europe, have inflated credit and money supply to keep the unemployment rate low.

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The economic community justified the use of debt by theorising that changes in a company’s debt/equity ratio had little or no effect on a company's cost of capital.

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But times have caught up with this use of debt, as the coronavirus pandemic and the economic recession have wreaked havoc in the businesses that have over-leveraged their balance sheets.

Standard & Poor’s recorded 88 corporate bond defaults through the second quarter of 2020. Millions of smaller businesses have gone under.

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Goldman Sachs has reported that the shares of companies with stronger balance sheets “have massively outperformed those with weaker ones….”

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But, the debt problem is all over the place. Sovereign debt throughout the world is pushing records everywhere; and debt is overwhelming many smaller sectors of the business community.

In South Africa, we have a different problem with the cost of capital being inflated by sovereign risk. This means that the real rate of return that companies have to achieve to compete with government bonds at 9% plus equity risk premium of 5% is 14%.

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While the rest of the world pumps more liquidity into the system, South Africa is paddling in the other direction.

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Brian Kantor, economist and head of the Research Institute at Investec Wealth & Investment puts it this way:

“Assume an investment world with income, initially 100, expected to grow at 5% p.a. over the next 20 years. Assume a developed world discount rate of 6% - 1% which is all that is available from government bonds, plus an assumed 5% extra for risky equity. The present value of this expected income or cash flow stream will be 320. Moreover, 81% of its current market value can be attributed to income expected after 5 years. The same business, with the same prospects in SA, and with the same risk premium, but competing with government bonds offering 9%, would have future income discounted at 14% p.a. That is at more than double the discount rate applied to an averagely risky investment in the developed world. It would have a present market value of 116, about a third lower. And, of which, only 54.9% of its present market value will be attributed to income to be expected after 5 years. Inexorably forcing such a business to adopt a much shorter focus with far fewer viable investment opportunities.”

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The one message that President Cyril Ramaphosa’s administration must understand is that reforms should be aimed at reducing the cost of capital. Anything short of that will not see the necessary investment flowing into the real economy, and growth – with all the jobs and prosperity and good things that are tucked into its slipstream – will remain as elusive as the status quo is stultifying.